The Buy-and-Holders say that stocks are always the best asset class. They acknowledge that stocks are more risky; prices sometimes fall hard. But they say that the losses are always recovered in time. So stocks are always best. Investors should put some money in cash for emergencies and some in bonds to reduce the volatility of the overall portfolio. But stocks are best.
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That can’t be so. All of the asset classes that investors invest in are part of one large market of investment choices. If one asset class is always best, word would get out that that was so and investors would drive up the price of that asset class until it no longer was best. The appeal of all of the asset classes waxes and wanes. No one asset class is best at all times.
Stocks Are Always The Best Asset Class
What people miss is that the thing that investors care about most is recent performance. When stock prices are rocketing, the popularity of the asset class increases while its long-term value proposition diminishes. That popularity influences the analyses that are used to understand the market. The very idea that stocks are always the best asset class is the product of academic ideas that caught on during a long bull market. When the bull market passes (they all do), the idea that stocks are always the best asset class will pass with it.
The most compelling example of this is what happened in January 2000. Stocks were priced so high that the most likely 10-year return was a negative number. And low-risk asset classes like Treasury Inflation-Protected Securities (TIPS) and IBonds were offering a guaranteed long-term return of 4 percent real. That’s a crazy return for a low-risk asset class. According to Modern Portfolio Theory, it shouldn’t be possible. If we were capable of being entirely objective about stock investing (we aren’t), we would have looked at that 4 percent real return as a puzzle that we needed to solve to come to a better understanding. Instead, we moved on from the puzzle quickly. We don’t want to know the lessons that solving it would teach us.
TIPS and IBonds paid crazy returns at that time because stock prices had increased 126 percent in the preceding four years. Those four years of crazy returns made it virtually impossible for anyone to think clearly about the subject of stock investing. We are still paying for those four years of insanity today. For the 21 years since, the annualized real return for stocks has been slightly under 5 percent real, a return 1.5 percent lower than the usual long-term average return. Losing 1.5 percentage points of return every year for 21 years running is a big deal. And that’s before the price crash that will someday bring the CAPE level back to 16, a big drop from the mid-30s level where it has resided lately. Any investment professional who tried to talk to investors about the risks of high stock prices at that time was ostracized. He was lucky if he didn’t find himself looking for a new job.
Super High Stock Prices
So TIPS and IBonds became far better asset classes for a time. But do the investors of today even know that? Stock prices are super high today. So information bits that reflect poorly on this asset class are sent down the memory hole. The situation that applied in January 2000 would be well worth examining as there are similarities (as well as some differences — there are no safe asset classes offering a return of 4 percent real today) that apply. But those lessons are not lessons that most investors want to learn at this point in the proceedings.
Say that we see a price crash within the next year or two or three. It could happen. I believe that it will happen. Will people still be saying that stocks are always the best asset class? Going by what we can learn from the historical record, I would venture a guess that they will not. Stocks are widely perceived as always being the best asset class only at times when they are so popular that they are priced to not be the best asset class. It’s a prediclement!
The people who we go to to obtain investment insights are influenced by what is going on around them at the time, just like everyone else. Even academics are insufficiently detached from the goings on of the market to be able to exhibit independence of thought at such times. The academic research will not be saying the same thing when the CAPE is again 8 as it says now when it is 36. The realities of the current day weigh too heavily on people’s minds to permit them to offer insights that work in all valuation environments.
Shiller’s research showing that valuations affects long-term returns dates back to 1981. The longest and strongest bull market in U.S. history started at that time. So we have not yet had a chance to see people react to his findings at a time when prices were coming down hard and then remaining at the new lower levels for a good stretch of time. If prices crash in the not-too-distant future, we will all get to “enjoy” that experience for the first time. I put the word “enjoy” within scare quotes because it will be a horrible thing to live through. But I do believe that it will bring on a learning experience. The trick at that time will be persuading people that stocks are not always the worst of all investment classes.
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